The Complete Guide to Cryptocurrency Tax Audits

Afraid of being audited by the IRS for your cryptocurrency holdings? 

Going through an IRS audit is a long and tedious process. To help cryptocurrency investors better understand how they can deal with this process, we spoke to a variety of tax experts with experience dealing with cryptocurrency tax audits and wrote this article based on their insights. 

By the time you finish reading, you’ll understand the steps you can take to reduce your chances of being hit with a substantial penalty at the end of the audit process (and minimize your odds of getting audited in the first place). 

Why would I be selected for an IRS audit? 

There are multiple reasons why you may have been selected for a cryptocurrency audit. Sometimes the answer is simply bad luck — your return may have been randomly selected through the IRS’s statistical formula. 

It is also possible that the IRS has reason to believe you are underreporting your cryptocurrency taxes or that you were conducting business with another party who is also being audited.  

Can the IRS identify my cryptocurrency transactions if I don’t report them? 

While most cryptocurrency transactions are anonymous or pseudo-anonymous, most blockchains are simply public ledgers available for anyone to view. While it can be difficult to link specific wallets to specific individuals, the IRS has in the past given contracts to data companies like Chainanalysis to catch tax cheats. 

Additionally, major exchanges like Coinbase and Kraken already report user information to the IRS. The upcoming American infrastructure bill will expand the scope of existing regulations, requiring any party that facilitates a cryptocurrency transaction to report tax information to the IRS for all relevant users. 

How does a cryptocurrency tax audit work? 

Typically, auditors look at financial records including your cryptocurrency trade history, bank account statements, credit card payments, loan payments, tuition costs, and insurance payments. If your costs are significantly higher than your reported income, the IRS may see it as a sign that you are hiding income.

Audit examiners may not have a deep understanding of cryptocurrency. However, the IRS does employ a team of behind-the-scene crypto experts to review documents and help guide the audit examiner through the process. 

How long a tax audit takes varies heavily depending on the specifics of your situation such as the complexity of your transaction history and the specific issues being discussed. There may be further rounds of questioning if the audit process reveals discrepancies in your tax filings. 

When the audit examiner finishes the process, you will be given a letter explaining the IRS’s findings and assessing the amount you owe in taxes. You will be given 30 days to appeal the decision. 

If the IRS finds evidence that you may have committed tax fraud or tax evasion, they may refer your case to the Department of Justice. 

How to avoid a cryptocurrency audit 

Unfortunately, there is no way to completely eliminate the risk of a tax audit. However, there are steps you can take to minimize your likelihood of being selected for one. 

Accurately report your crypto earnings

Some of the crypto information that investors should report to avoid an audit include: 

• Your complete cryptocurrency transaction history 
• The accounting method used to calculate capital gains (FIFO, LIFO, or HIFO) 
• Any assumptions that are not represented within the data 
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Of course, accurately reporting crypto taxes is often easier said than done. Because crypto investors often use multiple exchanges and wallets, it can be difficult to find data on every buying and selling event. 

Cryptocurrency tax software like CoinLedger can help. The platform supports dozens of automatic integrations with popular exchanges like Coinbase, Gemini, and Kraken. All of your transactions will be synced automatically, allowing you to file an accurate tax return in minutes. 

Explain steep rises/falls in income 

A steep fall in income or a steep rise in expenses may look suspicious. Be sure to provide additional paperwork that explains such events in detail. 

Double check your tax return 

Remember, a simple mathematical mistake in your tax returns can increase your risk of being audited. If you have conducted a large number of cryptocurrency transactions, be sure to double check your calculations. 

Don’t over-report your home deductions 

If you’re running a cryptocurrency-based business such as a mining operation, you do have the option to deduct business-related expenses. However, it’s important to remember that claiming unusually large deductions in proportion to your income may draw the scrutiny of the IRS. 

In addition, we recommend keeping documentation of all associated expenses of running your business in case of an audit. 
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